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Why RSP’s Outperformance Will Fade

We’re generally pretty skeptical of better mousetraps around here, especially when people start kicking the word “alpha” around. So when we were building the methodology behind our ETF Analytics platform, we had big arguments about how to handle ETFs that claim to have a strategy to beat the market.

In the end, being geeks, we decided to let the math do the speaking. So we take every ETF and measure it against a naive benchmark for its targeted exposure, and we run all the regressions, and we calculate alpha and beta and R 2 and all those wonderful nerdy stats.

But then we also go a step further—it’s not enough to show that your strategy generates alpha, you have to show you’ve generated statistically significant alpha. That means we use statistical tests that ask the question, What are the chances this result is right? And we set a pretty high bar:90 percent confidence.

To be honest, not many ETFs pass that test, and so not many ETFs get points for generating alpha in our system.

One of the ETFs that did, for quite some time, was the Guggenheim S'P 500 Equal Weight ETF (RSP | A-72). In fact, as recently as Oct. 31, we reported that RSP was generating nearly 5 percentage points of annualized alpha versus the S'P 500 Index.

I’ll be honest:It didn’t take all our fancy math to see that something cool was happening. Here’s the chart:

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That’s a chart anyone can love.

Of course, there are all sorts of things that would plot higher lines on the chart. Something is always up. The question is, How much risk are you taking for that extra juice? And that’s where the math comes in. Consider how this exact same one-year chart looks, just a week later:

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It looks nearly identical. RSP is still outperforming over the period by about 5 percentage points. But in this one-week period, our confidence in RSP’s outperformance went from about 97 percent to less than 90 percent. And that’s where the math can be your friend.

So what happened? Why are we no longer strong believers in the magic of equal weighting? Well, think about the components of any outperformance. Sure, you want to invest in things that will go up more than the benchmark, but not at any cost. If you invested in a coin-flip bet (which is, believe it or not, an actual casino game in Australia) you can get 100 percent returns in one day! Of course, 50 percent of your time, you’re going to lose all your money.

There are many ways of measuring that increased risk. In our Analytics platform, we generally look to beta to measure how a given ETF is moving versus the market. RSP’s beta has held steady in the 1.05-1.06 range in both periods, meaning that it’s generally been a slightly “juicier” version of the large-cap equity market, going up a bit more on up days, and down a bit more on down days. Your expectation should be that just from the beta, when the S'P is up 30 percent, RSP should be up 31.5 percent.

The problem is that beta and alpha come out of the same calculation, and beta doesn’t tell you by itself how reliable the calculation is. That reliability comes, at heart, from the variability inside the data. And the simplest question to then ask is, On a day-to-day basis, is RSP more volatile than the market?

And that’s where the really interesting part is. Here’s an output from Bloomberg looking at the rolling 30-day volatility of RSP and SPY. RSP is the white line:

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So what changed in the past week? Not much. The volatility of both ETFs went up. But what fell off the one-year chart—and way back in October and November 2012? That was a very interesting period in the history of RSP. During the fall of 2012, as the market corrected a few percentage points, RSP actually had a window in which it was not only outperforming the S'P 500, it was doing so while taking less day-to-day risk.

That persisted until the spring, when RSP started showing its true colors a little more clearly—that of a slightly riskier take on the S'P 500.

So what’s the moral of the story? It’s that in the immortal words of Robert Heinlein:“TANSTAAFL”—or, There Ain’t No Such Thing As A Free Lunch.

RSP had its moment in the sun, where the nerdy math made everyone feel really great about the chart, but as that moment fades, it’s important to recognize the charts can often still look pretty much the same.

RSP is a great ETF for expressing an opinion about the large-cap U.S. equity market—an opinion that the smaller-cap stocks will outperform, that overconcentration on a few dozen names can be unwise, and that you’re willing to take the risk of the midcap bias rather than the concentration risk of market-cap weighting.

But you need to recognize that’s what you’re doing:expressing an opinion, not cashing a risk-free check.